How to Value Facebook’s $19 Billion WhatsApp Deal

The big question in Facebook 's $19 billion deal for WhatsApp: Did the social network overpay for the messaging company, or is the price justifiable?

The deal initially elicited some sticker shock on Wall Street, but analysts and shareholders have increasingly come around to the fact that Facebook is paying up for WhatApp’s vast user base. The company says it’s adding one million users a day and already has 450 million users, compared to 241 million for Twitter.

Still, is a $19 billion price tag warranted for an unprofitable company that reportedly only generated $20 million in revenue last year?

Aswath Damodaran, a finance professor at the Stern School of Business at New York University who teaches a course on stock valuations, offered some answers.

In a blog post, Mr. Damodaran explained how it’s worth looking at this deal from both the trader and the investor perspective.

“When you are wearing your investor cape, you can be mystified by what traders do and react to, and if you are in your trader mode, you are just as likely to be bamboozled by the thought processes of investors,” he said.

From a long-term investor’s point of view, he finds it difficult to justify the deal. “I realized very quickly that this would not only be futile but frustrating,” he said. Normally for a company to warrant a $19 billion value, it would need to generate about $1.5 billion in after-tax income, Mr. Damodaran said.

WhatsApp is nowhere near that.

What’s more disconcerting is a significant portion of the messaging company’s users are teenagers, which is “terrifying as a business proposition,” he says. “The only group that is less dependable (and predictable) than teenagers is a group of teenagers who text a lot.” From Mr. Damodaran:

“At this stage, if you are an investor, you have two choices. The first and less damaging one is to accept that social media investing is not your game and move on to other parts of the market, where you can find investments that you can justify with fundamentals. The second is to go from frustration (at being unable to explain the price) to righteous anger or indignation about bubbles, irrationality and short term traders to trading on that anger (selling short). I would strongly recommend that you not go down this path, since it will not only be damaging to your physical health (it is a sure fire way to ulcer and heart attacks) but it may be even more so for your financial health. While you may be right about the value in the long term, the pricing process rules in the near term.”

On the flip side, the deal not only looks more attractive if viewed from a trader’s perspective, “but it may actually be viewed as a positive,” he said.

Putting the fundamentals aside for a second, he notes that the market is clearing pricing many of these social-media companies on users, user growth and engagement. “While the value side of you may be telling you that you cannot pay dividends or buy back stock with users (you need cash flows), remember that the pricing game is not about what you or I think makes sense but what traders care about,” Mr. Damodaran said.

Users and user growth are the metrics that Facebook found so valuable in this deal. These benchmarks also make WhatsApp look more valuable than other social-media companies.

Some back-of-the-envelope math shows Facebook is paying just $42 per WhatsApp user, whereas Facebook trades at $145 per user and Twitter trades at $128 per user.

Again, these aren’t tried and true fundamental metrics. But that’s the point; for better or for worse, this is what the market is fixated on right now.

“If you are a trader, play the pricing game and stop deluding yourself into believing that this is about fundamentals,” he said. “Rather than tell me stories about future earnings at Facebook/Twitter/Linkedin, make your buy/sell recommendation based on the number of users and their intensity, since that is what investors are pricing in right now.”

So, what’s the takeaway? Mr. Damodaran says Facebook needs to attract more Whatsapp users to Facebook’s platform and “hope and pray that the market’s focus stays on the number of users.” That will give it the opportunity to monetize users and ultimately benefit from the deal.

What about the investor? Here’s Mr. Damodaran’s bottom line:

“My experience with markets has been that no one has a monopoly on virtue and good sense and that the hubris that leads to absolute conviction is an invitation for a market take-down. To investors who view deals like the Whatsapp acquisition as evidence of irrational exuberance, remember that there are traders who are laughing their way to the bank, with the profits that they have collected from their social media investments. Similarly, for traders who view fundamentals and valuation as games played by eggheads and academics, recognize that mood and momentum may be the dominant factors driving social media companies right now, but markets are fickle and fundamentals will matter (sooner or later).”